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Monday, March 31, 2008

In my previous posting I discussed some papers that showed recessions to be good on balance for your health. However, a paper by Rafael Di Tella, Robert J. MacCulloch and Andrew J. Oswald titled "The Macroeconomics of Happiness" finds that there are large psychological costs to recessions. Since emotional health affects physical health, it stands to reason that these findings indicate recessions are bad for health.

We show that macroeconomic movements have strong effects on the happiness of nations. First, we find that there are clear microeconomic patterns in the psychological well-being levels of a quarter of a million randomly sampled Europeans and Americans from the 1970s to the 1990s. Happiness equations are monotonically increasing in income, and have similar structure in different countries. Second, movements in reported well-being are correlated with changes in macroeconomic variables such as gross domestic product. This holds true after controlling for the personal characteristics of respondents, country fixed effects, year dummies, and country-specific time trends. Third, the paper establishes that recessions create psychic losses that extend beyond the fall in GDP and rise in the number of people unemployed. These losses are large.

Thursday, March 27, 2008

Yes, there is a silver lining to the recession of 2008: your health should improve. At least that is the finding from a number of empirical studies. These studies indicate recessions help induce behavioral changes that are conducive to healthier lifestyles. Christopher Ruhm, a seminal figure in this literature, explains how this process could work: "Individuals might adopt healthier lifestyles when the economy weakens because increases in non-market time make it less costly to undertake health-producing activities such as exercise or the consumption of a healthy diet. Reductions in incomes and employment related stress could also decrease the frequency of 'self-medication' by smoking and drinking." (source) These results are contrary to what I expected, though consistent with my own research that shows some individuals get more religious during economic downturns. Advocates for recession's 'cleansing effects', then, may find this research to bolster their case.

Using microdata for adults from 1987 to 2000 years of the Behavioral Risk Factor Surveillance System (BRFSS), I show that smoking and excess weight decline during temporary economic downturns while leisure-time physical activity rises. The drop in tobacco use occurs disproportionately among heavy smokers, the fall in body weight among the severely obese and the increase in exercise among those who were completely inactive. Declining work hours may provide one reason why behaviors become healthier, possibly by increasing the non-market time available for lifestyle investments. Conversely, there is little evidence of an important role for income reductions. The overall conclusion is that changes in behaviors supply one mechanism for the procyclical variation in mortality and morbidity observed in recent research.

Panel data econometric methods are used to investigate how the risk of death from coronary heart disease (CHD) varies with macroeconomic conditions after controlling for demographic factors, fixed state characteristics, general time effects and state-specific time trends. The primary analysis covers 1979-1998, with a supplemental investigation of medical procedures during 1994-2003. A one percentage point reduction in unemployment is predicted to raise CHD mortality by 0.75 percent, corresponding to almost 3,900 additional fatalities. The increase in relative risk is similar across age groups implying that senior citizens, who have the highest fatality rates, account for most of the extra deaths.

This study uses aggregate data for 23 OECD countries over the 1960-1997 period to examine the relationship between macroeconomic conditions and deaths. The main finding is that total mortality and deaths from several common causes rise when labor markets strengthen. For instance, controlling for year effects, location fixed effects, country-specific time trends and demographic characteristics, a one percentage-point decrease in the national unemployment rateis associated with growth of 0.4 percent in total mortality and the following increases in causespecificmortality: 0.4 percent for cardiovascular disease, 1.1 percent for influenza/pneumonia,1.8 percent for liver disease, 2.1 percent for motor vehicle deaths, and 0.8 percent for otheraccidents.

... Statistically and demographically significant results show that the decline of total mortality and mortality for different groups, ages and causes accelerated during recessions and was reduced or even reversed during periods of economic expansion—with the exception of suicides which increase during recessions. In recent decades these effects are stronger for women and non-whites.

Vincent Reinhart, former director of the Division of Monetary Affairs at the Federal Reserve and coauthor with Ben Bernanke on severalpapers, had an article in the Wall Street Journal titled "Our Overextended Fed." In this piece, Reinhart takes to task his former colleagues at the Fed for setting moral hazard-creating precedents as well sending panic signals to investors. His frank rebuke of the Fed's actions are surprising for a former high-ranking Fed official.

In the past few weeks, the Federal Reserve has fundamentally redefined the role of a central bank in a market economy.

Almost one-half of our nation's central bank balance sheet -- more than $400 billion -- is exposed to credit risk through new lending facilities. It has also entered an open-ended commitment to use its discount window to back stop major securities firms. Those efforts will influence the depth of the recession that the U.S. economy has likely already entered, and will leave a durable imprint on the financial landscape for many years to come.

[...]

The desire on the part of policy makers to draw a line defending the existing structure of the financial system is understandable. But one can wonder if the trenches the Federal Reserve has dug are this generation's Maginot Line -- ineffective in defense and costly in the long run.

The Federal Reserve put its balance sheet in harm's way to give assurance to Bear Stearns's creditors and extended that protection to the other primary dealers. In doing so, the Board of Governors of the Federal Reserve had to determine unanimously (since they only had five members at the time) that these were "unusual and exigent" circumstance and that failure to lend to Bear would have adverse consequences for the U.S. economy. The signaling aspect of that decision cannot help but have adverse consequences for investors' willingness to take on risk.

Moreover, the implicit declaration that a midsize investment bank was systematically important puts any firm at least as big as Bear in the cross-hairs of speculators. In coming days, how can the Federal Reserve turn away another like-sized entity, whether primary dealer or not, that is suddenly in the marketplace's disfavor for having used leverage to borrow at short-term maturities to fund longer-term obligations?

In such circumstances, the Federal Reserve's $900 billion balance sheet will not look that big. And the Federal Reserve will have ceded control of its balance sheet to the needs of private-sector entities.

More seriously, the Federal Reserve's action can only be viewed as rewarding bad behavior. Remember that Bear opened this financial crisis when it revealed problems at its sponsored hedge funds last June. That it did not spend the next nine months resolving its problematic positions and getting sufficient capital did not prevent it from getting a "get out of jail free" card from the Federal Reserve.

Monday, March 24, 2008

I am slated to teach two sections of undergraduate Money & Banking in the fall semester and am already being accosted by the book reps. Talking with the book reps started me thinking--are there any monetary textbooks out there that will make sense in the fall? Given the ongoing meltdown in financial markets and the many central banking innovations that have taken place in response (e.g. TAF, TSLF), I suspect many, if not all, monetary texts will have gaping holes in them. So I was pleased to read Jim Hamilton was thinking along similar lines when wrote the following:

If you took a college course on monetary policy more than six months ago, what you learned has already been rendered out of date by the big changes Bernanke has implemented in how monetary policy can be used.

So are there any monetary textbooks out there that will reflect the new realities of central banking? Fortunately, we live in a world of the internet and economic blogging where all you need to know about this crisis is just a click away. Still, it would be nice to have a textbook that is current for students.

Friday, March 21, 2008

There seems to be many observers comparing the current economic crisis to that of the Great Depression. Amity Shales does a good job reviewing and correcting some of the comparisons. Following her lead, I want to briefly comment on Paul Krugman's latest NY Times piece titled "Partying Like It's 1929." Krugman makes the case that we have forgotten an important lesson learned from this period: regulating the financial system. One of the main contributors to the Great Depression was the massive collapse of the banking system--about 9000 banks fell. Krugman believes this development turned what would have been a normal recession into the Great Depression. While some economists would debate whether this was the most important factor, no one disputes that it turned a bad situation into something worse. Here is Krugman:

What turned an ordinary recession into a civilization-threatening slump was the wave of bank runs that swept across America in 1930 and 1931.

This banking crisis of the 1930s showed that unregulated, unsupervised financial markets can all too easily suffer catastrophic failure.

As the decades passed, however, that lesson was forgotten — and now we’re relearning it, the hard way.

Krugman fails to mention some important details about the banking system in the 1920s and 1930s that undermines his thesis that it was "unregulated, unsupervised financial markets" that caused the banking crisis of the 1930s. First, there is a huge literature that shows a key reason for the massive banking collapse was the unit banking laws of the time--laws preventing banks from having more than one branch. The absence of interstate, and sometimes intrastate, branch banking meant bank assets were poorly diversified. For example, a bank in Kansas would hold loans mostly from farmers, making it susceptible to swings in the agricultural market. Now imagine if that same Kansas bank had branches throughout the nation. It's balance sheet would now include loans to sectors of the economy other than just farming. Simply put, its balance sheet would more diversified and better insulated from negative economic shocks.

A second advantage of branch banking is that even if a non-rational, panic-driven bank run starts it can be nipped in the bud at the onset. Imagine now the panic erupts at the bank in Kansas. People rush to bank and a big line forms outside. Instead of running out of reserves, the bank in Kansas can now pull in reserves from its branch bank in the next county. This will stem the panic and prevent it from becoming systemic.

Now, are these ideas merely theoretical? No; one needs to look no further than Canada during the Great Depression. Canada, unlike the United States, had nationwide branch banking. Guess how many banks shut down in Canada during the Great Depression? Zero. Yes, you read that correctly, zero banks shut down in Canada while around 9000 shut down in the United States. Oh, did I mention that Canada did not have a central bank during the worst part of the Great Depression? And yes, the real economy was hit just as hard in Canada as it was in the United States.

A good survey of the branch banking literature is found in Charles Calomiris' book, U.S. Bank Deregulation in Historical Perspective. It is also worth noting that some researchers such as David Wheelock also point out that experiments by state governments with deposit insurance in the 1920s also contributed to the problem. His research finds that deposit insurance "caused more entry and encouraged greater risk-taking than would have otherwise occurred and, hence, the banking systems of states with insurance might have been more vulnerable to a decline in economic activity." (source here)

So Krugman's claim that it was the "unregulated, unsupervised financial markets" that caused the bank runs misses some important details. If I were writing Krugman's column I would say it was the "poorly designed banking system aided by a poorly run Federal Reserve" that contributed to the collapse of the banking system.

So if this is the season for making comparisons to the Great Depression, what is the relevant comparison for financial markets today? Are the financial market as poorly designed today as they were back then?

While grading papers yesterday, I listened to Tyler Cowen's EconTalk on monetary policy with Russ Roberts. Listening to Tyler's calm, soothing voice as he discussed all things monetary made the frustrations of grading all the more bearable. The discussion is definitely worth your time.

Amidst the Cowen-induced calm, however, I did have a momentary lapse into the land of angst when the topic of deflation was brought up. Roberts asked Cowen what would happened if the monetary base were frozen in a growing economy. Cowen correctly replied that there would emerge deflationary pressures. He then proceeded to say, though, that such a development would be a destabilizing outcome since people are not capable of handling a world of falling prices. Owing to "human irrationality", Cowen claimed worker morale would suffer if laborers got a 3% nominal wage cut even if the price level fell 4% in an expanding economy. Moreover, maintaining inflationary expectations among workers provides an "easy way to trick people into a wage cut" if needed.

Wow--is this really Tyler Cowen or his evil twin Tyrone Cowen? I certainly did not expect this response from Tyler. Let me begin my reply to whichever Cowen it may be by stating up front I do not advocate a freezing of the monetary base (although something like that happened after the U.S. Civil War). I am, though, open to a monetary policy rule that allows for productivity changes to be more fully reflected in the price level--George Selgin's Productivity Norm rule comes to mind--because doing so may actually improve macroeconomic stability (see here). Such an approach to monetary policy would also imply mild deflation at times, so Cowen's critiques still apply and must be examined.

So, Cowen believes people are subject to a form of money illusion that only allows them to be fully functional when prices are rising. In short, people are too dumb to distinguish between nominal and real values. This understanding is surprising for someone who champions a more libertarian view of the world, one where individuals are capable of making choices--such a distinguishing between nominal and real values--that improve their welfare. Empirical evidence suggests Cowen should take more seriously his libertarian instincts on this issue. Michael Bordo and Andrew Filardo in their article "Deflation in Historical Perspective" review the literature on this topic and conclude

... that such notions of downward wage inflexibility that were formed during the Great Inflation may in fact be regime-dependent. It is possible that once a low inflation or moderate deflation environment were to become more familiar, the past psychological aversion to downward nominal, rather than real, movements would become less of a constraint.

We have looked for evidence of downward nominal wage rigidity in the nineteenth-century United States, using data that allow clear comparisons between historical and modem patterns. We find no evidence of downward nominal wage rigidity in the historical data, especially when they include the various monetary regimes of the 1860's and 1870's. One interpretation consistent with our results would be that the modern wage floor reflects employers' fear of damaging employee "morale" by violating social norms and concepts of fairness (as described by Bewley, 1999) rather than a fundamental preference on the part of workers. Unlike fundamental preferences, social norms can change with the economic environment. Under monetary regimes delivering very low trend inflation, such as the postbellurn deflation, a norm that enforced downward nominal wage rigidity could become costly for individual employers and employees, as well as for society as a whole… It seems safe to conclude… that U.S. historical experience fails to support the proposition that downward nominal wage rigidity is a fundamental feature of employment that prevails under any circumstances.

Cowen's view, then, of downward nominal wage rigidity is more representative of the inflationary times in which we live than a universal truth.

As I mentioned above, there are also reasons related to macroeconomic stability that should make Cowen more open to deflation, at least the benign form. That is why I like George Selgin's Productivity Norm rule. (In case you missed it, here are my postings on the relationship between macroeconomic stability and benign deflation.) From what I can tell, Cowen's colleague Bryan Caplan takes this latter point more seriously. Sometime they should get together and discuss George Selgin's "Less than Zero".

Update: G. Selgin makes an excellent point in the comments section--there is no need for a downward wage adjustment under the productivity norm. The decline in the price level will guarantee a rise in the real wage. Thus, the issue of whether wages are downwardly mobile is really inconsequential with productivity norm.

Friday, March 14, 2008

I never thought I would see the day when observers are talking about coordinated intervention by policymakers to strengthen the dollar. Here is the FT commentary:

Selling the dollar is now close to a one-way bet. So great is concern about the health of the US financial system that the dollar traded below Y100 on Thursday, and above $1.56 against the euro. The danger of a dollar rout is rising, and the Federal Reserve, European Central Bank and Japan’s Ministry of Fi­nance should co-ordinate intervention to slow the greenback’s fall.

And here, the WSJ Real Times Economics blog reports Stephen Jen of Morgan Stanley is talking coordinated dollar intervention. Wow, if these suggestion come to fruition it would be like the Plaza Accord of 1985 in reverse.

Of course, as Brad Sester notes, the dollar is already being propped up by monetary authorities in Asia and oil-exporting countries. Based on the FT's commentary, it sounds like the calls for coordinated intervention are intended for the G7 nations. Unless the Asian and oil-exporting countries change policies, however, I fear a coordinated propping up of the dollar will only add to global economic imbalances... everyone seems afraid of the needed adjustments.

Amid the carnage in the financial markets and the related response by the Fed, Edmund Phelps steps back to question modern monetary economics:

In recent times, most economists have pretended that the economy is essentially predictable and understandable...Today we are seeing consequences of this conceit in... central banking. "[R]ule-based" monetary policy, by considering uncertain knowledge to be certain knowledge, [is] taking us in a hazardous direction.

[...]

In the 1970s... a new school of neo-neoclassical economists proposed that the market economy, though noisy, was basically predictable. All the risks in the economy, it was claimed, are driven by purely random shocks -- like coin throws -- subject to known probabilities, and not by innovations whose uncertain effects cannot be predicted.

This model took hold in American economics and soon practitioners sought to apply it... Policy rules based on this model were adopted at the Federal Reserve and other central banks.

The neo-neoclassicals claimed big benefits from these changes... They asserted a decline in "volatility" in the U.S. economy and credited it to the monetary policy rules at the Fed.

Current experience is putting these claims to the test.

[...]

The claim for rule-based monetary policy is weak on its face. In deciding on the short-term interest rate it controls (the Fed funds rate) the Federal Reserve thinks about the "natural" interest rate -- the rate needed if inflation is neither to rise nor fall. Then the Fed asks whether the expected inflation rate is above or below the target. The Fed also asks whether the unemployment rate is above or below the medium-run "natural" unemployment level -- the level to which sooner or later the actual rate will return.

But the medium-run natural unemployment rate and the natural interest rate are anything but certain...

The Fed's view seems to be that the medium-term natural unemployment rate is stable. Thus the rise of actual unemployment in the past year is wholly or largely temporary... Yet there are good reasons why the medium-term natural unemployment rate may be a lot higher now than before...The Fed's view [also] seems to be that the natural interest rate has decreased with the business downturn. But this too is uncertain...

Phelp's discussion boils down to a RBC vs. New Keynesian interpretation of current events. He is arguing that maybe the economy is not temporarily deviating from its long-run trend growth path, but rather there has been a permanent shift. If so, then assumptions about the natural rate of interest and full employment can be way off the mark leading to distortionary monetary policies by the Fed.

Phelp's concern about a falling natural rate of interest seems particularly compelling at this time. Robert Gordon (via Michael Mandel) believes the productivity boom of the 1995-2004 is over. Since productivity is a key determinant of the natural interest rate, it stands to reason that the natural interest rate has fallen. This development would imply recent Fed actions may have a distortionary effect down the road. Below is a graph of trend productivity from Robert Gordon:

[The author of the article,] Evans-Prichard [,] is not saying that commodities will go into a long-term decline. However, given a 20% runup in many indices in a mere two months after a 30+% increase last year, some observers deem the market to be overbought and due for a correction. Evans-Pritchard points out that if you believe that the US and Europe are going to enter a recession (insiders believe that European financial institutions will soon see the kind of stress their US peers have suffered), Chinese demand isn't strong enough to justify continued robust prices (ex agriculture).

As parting food for thought, I have posted below two graphs of the commodity-tracking CRB Index.

Wednesday, March 5, 2008

AMID increasingly turbulent credit markets and ever-weaker reports on the economy, the Federal Reserve has been unusually swift and determined in its lowering of the overnight lending rate...

The central question for the economy is this: Will this medicine work? The same question was asked repeatedly in Japan during its “lost decade” of the 1990s. Unfortunately, as was the case in Japan, the answer may be no.

If the American economy were entering a standard cyclical downturn, there would be good reason to believe that a timely countercyclical stimulus like that devised by Washington would be effective. But this is not a standard cyclical downturn. It is a post-bubble recession...

For asset-dependent, bubble-prone economies, a cyclical recovery — even when assisted by aggressive monetary and fiscal accommodation — isn’t a given. Over the past six years, income-short consumers made up for the weak increases in their paychecks by extracting equity from the housing bubble through cut-rate borrowing that was subsidized by the credit bubble. That game is now over...

Japan’s experience demonstrates how difficult it may be for traditional policies to ignite recovery after a bubble. In the early 1990s, Japan’s property and stock market bubbles burst. That implosion was worsened by a banking crisis and excess corporate debt. Nearly 20 years later, Japan is still struggling.

There are eerie similarities between the United States now and Japan then. The Bank of Japan ran an excessively accommodative monetary policy for most of the 1980s. In the United States, the Federal Reserve did the same thing beginning in the late 1990s. In both cases, loose money fueled liquidity booms that led to major bubbles...

Like their counterparts in Japan in the 1990s, American authorities may be deluding themselves into believing they can forestall the endgame of post-bubble adjustments. Government aid is being aimed, mistakenly, at maintaining unsustainably high rates of personal consumption. Yet that’s precisely what got the United States into this mess in the first place — pushing down the savings rate, fostering a huge trade deficit and stretching consumers to take on an untenable amount of debt...

American authorities, especially Federal Reserve officials, harbor the mistaken belief that swift action can forestall a Japan-like collapse. The greater imperative is to avoid toxic asset bubbles in the first place. Steeped in denial and engulfed by election-year myopia, Washington remains oblivious of the dangers ahead

Sunday, March 2, 2008

Abstract: Over the Great Moderation period in the United States, we find that corporate credit spreads embed crucial information about the one-year-ahead probability of recession, as evidenced by both in- and out-of-sample fit. Furthermore, the incidence of "false positive" predictions of recession is dramatically reduced by utilizing a bivariate model that includes a measure of credit spreads along with the slope of the yield curve; indeed, these bivariate models provide much better forecasting performance than any combination of univariate models. We also find that optimal (Bayesian) model combination strongly dominates simple averaging of model forecasts in predicting recessions.

Saturday, March 1, 2008

From the NY Times comes this figure depicting the geographic distribution of net employment gains for the 2000-2007 period. The Rusbelt, particularly Michigan, continues to bleed jobs...hello structural unemployment.

... It’s a shame the Democratic candidates for president feel they have to make trade – specifically NAFTA – the enemy of blue-collar workers and the putative cause of their difficulties. NAFTA is not to blame...

NAFTA has become a symbol for the mounting insecurities felt by blue-collar Americans. While the overall benefits from free trade far exceed the costs, and the winners from trade (including all of us consumers who get cheaper goods and services because of it) far exceed the losers, there’s a big problem: The costs fall disproportionately on the losers -- mostly blue-collar workers who get dumped because their jobs can be done more cheaply by someone abroad who’ll do it for a fraction of the American wage. The losers usually get new jobs eventually but the new jobs are typically in the local service economy and they pay far less than the ones lost

Even though the winners from free trade could theoretically compensate the losers and still come out ahead, they don’t. America doesn’t have a system for helping job losers find new jobs that pay about the same as the ones they’ve lost – regardless of whether the loss was because of trade or automation. There’s no national retraining system. Unemployment insurance reaches fewer than 40 percent of people who lose their jobs – a smaller percentage than when the unemployment system was designed seventy years ago. We have no national health care system to cover job losers and their families. There's no wage insurance. Nothing. And unless or until America finds a way to help the losers, the backlash against trade is only going to grow.

Get me? The Dems shouldn't be redebating NAFTA. They should be debating how to help Americans adapt to a new economy in which no job is safe...